What investors need to know about bond ETFs

Money has been pouring into bond ETFs, thanks to uncertainty over the stock market.

  • By Ari I. Weinberg,
  • The Wall Street Journal
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Money has poured into bond ETFs this year, amid uncertainty about the direction of stocks. A net $75.2 billion flowed into bond funds listed on U.S. exchanges in the first half of the year, compared with $56.5 billion for U.S.-listed equity ETFs, according to news and analysis site ETF.com.

The case for most bond ETFs is simple. “Concerns about the global political and economic situation have helped drive assets into bond ETFs this year,” says Deborah Fuhr, managing partner and founder of London-based research firm ETFGI. Fixed-income assets generally serve in investment portfolios to counterbalance the volatility and risk common to stocks, especially in uncertain times.

But while the reason to buy bond ETFs may be simple, the market is less so. Investors have a multitude of choices. And while bond funds can help offset the risk of stocks, many carry substantial risks of their own. Here’s a broad look at what the market has to offer and a guide to the defining characteristics of a given bond ETF.

A big menu

Various ETFs hold debt of a range of maturities from many different issuers. Conservative investors tend to buy funds that hold only shorter-term debt issued by the U.S. government, which reduces exposure to sharp movements in interest rates and to credit risk. Others choose to build a more diversified debt portfolio, reaching for higher yields and taking on more credit risk, and mixing in debt from different types of companies, governments and other issuers.

Assets in what FactSet ETF director of research Elisabeth Kashner calls “plain vanilla” funds that track broad bond indexes have jumped 21% since the end of 2017 through returns and investment inflows. One thing to keep in mind about funds that track bond indexes, which is the most common type: Unlike most equity ETFs, bond ETFs don’t hold every security in the index they track, because bonds generally aren’t as liquid as stocks, so some may be difficult to buy. For example, a particular index might include 3,000 bonds, but an ETF tracking that index might hold only 1,000 of them.

Other areas of the market are growing far faster, according to FactSet. For example, actively managed bond ETFs, of all maturities and disciplines, have expanded assets by 82% to $61.2 billion since the end of 2017, and “bullet” or defined-maturity products—portfolios of bonds that all mature around the same time and then distribute cash to investors—have nearly doubled to $18.6 billion. Government-bond funds have grown 51% to $263 billion.

The variety of bond ETFs continues to grow. “Portfolio managers are trying to differentiate themselves and are more willing to explore products that cover the markets they want to be in but also have some differentiation,” says Barry Arnold, portfolio manager at Global View Capital Management in Waukesha, Wis. For example, Mr. Arnold has invested in the $1.1 billion VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL), which puts a spin on high-yield investing by holding high-yield debt that was once rated investment-grade but has been downgraded below investment grade. The idea is that such debt may be less risky than debt that was never rated investment grade.

What defines a fixed-income ETF

Issuer: The fixed-income securities, or in some cases loans, that ETFs hold can be obligations of governments, corporations, and even individuals through mortgage- and asset-backed securities. Asset-manager and research websites, such as Morningstar (MORN) and ETF.com, disclose the makeup of ETF portfolios, often daily.

Credit quality: Individual securities or loans are evaluated on their riskiness by credit-rating firms such as Moody’s (MCO) or S&P Global Ratings. With AAA being the safest, investment grade is generally rated at least BBB or Baa. High-yield or junk is any rating below that.

Maturity: From ultra short-term (maturing in less than a year) to long-term (think 30-year Treasurys), fixed-income ETFs disclose their maturity distributions as well as duration, a measurement of sensitivity to interest-rate fluctuations. A higher duration indicates greater price sensitivity to interest-rate changes up or down.

Yield: Higher yields generally indicate more risk, based on either the aggregate credit profile of the fund’s holdings or higher duration or both.

Strategy: Most fixed-income ETFs aim to track an index, but there are products that employ strategies that might better serve an investor’s particular needs, such as currency hedging on non-U.S. dollar debt or buying inflation-protected securities; others are actively managed or use a quantitative model to screen for environmental, social and governance (ESG) factors and more.

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